"The bill would prevent investment fund managers from paying taxes at capital gains rates on investment management services income received as carried interest in an investment fund. To the extent that carried interest reflects a return on invested capital, the bill would continue to tax carried interest at capital gain tax rates. However, to the extent that carried interest does not reflect a return on invested capital, the bill would require investment fund managers to treat seventy-five percent (75%) of the remaining carried interest as ordinary income. A transition rule would apply prior to January 1, 2013. This proposal is currently being estimated by the Joint Committee on Taxation.”

Not sure what carried interest on invested capital is, I suppose that is returns on the GP fund investment and if so that doesn't generate carried interest anyway. As to carried interest on GP commitments it looks like they just decided to tax it at ordinary income with an arbitrary 25% discount in order to get the deal done. Gotta love politics!

On the merits of the issue, I think what gets lost in the pedagogy of the debate is that tax policy is not a philosophy or an ideology – it is simply a technology. Tax policy is a tool used by the government to incentivize certain types of activities and discourage others. That is why taxes on tobacco are so high, why mortgage interest is deductible, why farmers in the Midwest are subisidized to grow corn (or often, to NOT grow corn in order to restrict supply and keep prices high) and why lots of techies get a tax break on their Priuses. It’s perfectly reasonable – and appropriate – for the government to make decisions about incentivizing certain types of activities and disincentivizing others.

(Reasonable and smart people can and have argued that such a government approach is NOT appropriate and argue that the government should not favor any activities over any others. While I don’t share their view, I recognize its intellectual validity. That argument, however, is much larger than the scope of this issue. As long as we have government tax policy that does incentivize some activities over others, I believe it is reasonable to discuss whether or not venture capital investments in small businesses are a good incentive or not).

So, the question for me is simply, should the government craft a tax policy that incentivizes the type of investing that venture capitalists do, or not? I am a strong believer that it should, with the caveat that for me, it is the *type* of investment and not the form or structure of the investor that matters. I believe the government should incentivize non-leveraged, long-term, high-risk equity ownership investments in companies founded by promising entrepreneurs who don’t personally have the financial wealth to fund the company themselves.

Angels do this kind of investing, and deserve to be incentivized by government tax code. VC’s do this kind of investing, and deserve to be incentivized by government tax code. Anyone else (banks, companies, overseas investors, etc) ought to be similarly incentivized. Not because it is the “right” or the “fair” thing to do, but because it is good government policy, because it creates economic growth and new jobs at a higher rate than any other form of incentive. Certainly more than growing corn for ethanol, or NOT growing corn in order to keep grain prices high.

Next, the question is, should government tax policy incentivize the creation of entrepreneurial value in start-up companies if the means of such creation is not purely via capital? Again, this is a reasonable debate to have. Lots of people have strong opinions about whether, in their personal view, venture capital investors “deserve” to be incentivized to add their networks and expertise and sweat equity alongside the entrepreneurs. If you are a person who holds the belief that a venture capitalist – by definition – does NOT add substantial value in the entrepreneurial wealth creation process, then it certainly is logical to argue that VCs should not be incentivized.

That said, however, the most important element of Jason’s post, in my view, is the slippery slope. If you are going to argue not from an incentivize/tax policy standpoint, but from a philosophical or structural “fairness” standpoint that ONLY cash investments can receive capital gains treatment, then you are actually arguing against a much larger portion of the economy than just VCs and carried interest. The majority of energy production, the majority of real estate development, a large number of small and family owned businesses, and nearly all startup entrepreneurial companies rely on the premise that some people contribute cash, others contribute other intangible assets ranging from IP to sweat equity, and in the end, they all benefit from capital gains tax treatment on the growth of a capital asset that results.

From a philosophical or ideological standpoint, if you want to argue that ONLY capital should be narrowly eligible for capital gains treatment, then you are inadvertently going to to eliminate the ability for company founders to be taxed at capital gains rates for the value they grow in their businesses. Along the way you’ll penalize everyone who started a restaurant with seed money from their uncle, everyone building apartments in their neighborhood using capital from third-party investors, everyone wildcatting for energy resources that the world desperately needs.

In summary, here is kind of how I boil down the issue:

1. Should capital gains have a differential tax rate than ordinary income? If you think not, then the rest of this issue is moot. If you think it should, because it stimulates a higher rate of capital formation and velocity of investment in the economy – which I believe it does – then move on…

2. Should capital gains tax treatment apply narrowly only to the investment of actual cash, or can it also be applied to the creation of wealth via the growth in value of capital assets (i.e. things that are bought and sold as capital assets, which separates it from things like sales commissions)? I.e. if you start a restaurant or a farm or a business or an natural gas well or an apartment complex, and you put in a small % of the $ but do all the work and own a large % of ownership of the asset, while others supply just the $, are you limited to capital gains tax treatment on just the $ you put in, or should you eligible for capital gains tax treatment on your entire share of ownership in the asset that you helped to build? If you think the answer is that cap gains tax should only apply to cash, then we’re done and the rest of this is moot. I believe, however, that it is reasonable for the government to adopt a tax policy – from a practical, if not a philosophical or ideological standpoint – that incentivizes such entrepreneurs, as it is one of the key ways our economy has remained vibrant. If you agree with me, then I would also argue that people who start technology companies, or people who work for them, ought to be entitled to similar incentives of capital gains tax treatment on the increase in value of their ownership stake, and not just the de minimus amount of $ they may have directly invested themselves.

3. If the government tax policy is going to incentivize the creation and long-term growth in value of capital assets in the form of restaurants, farms, wells, properties, and technology startups – and do so in a way that applies the capital gains tax incentive to the ownership stake of the owner and not narrowly to the $ they invested – then the next question is, who should be eligible for that incentive? Until now, the answer has been pretty clear: the tax applies to the ownership in the asset, not to the cash contribution, so if you build a great restaurant or farm or business or property, and sell it, you get capital gains treatment. Under the new proposals, however, you’re now looking at a different approach. So the question is, how do you decide who should be eligible, if you’re not solely relying narrowly on cash $ invested? If you think it should just be founders, or just employees, then what about companies that angels or VCs help found, or take a interim operational role with? Practically speaking, I think it is nearly impossible for the government to draw distinctions among different types of non-cash contributions to the growth of value of a capital asset, and I think the only way to do it is how we’ve historically done it: we let the people involved neogitate among themselves how much ownership will go to those providing intangible value and how much ownership will go to those providing cash. If you and your uncle agree that he gets 80% or 99% or 60% of the restaurant’s ownership for providing nearly all the capital, and you get the rest for working the 90 hour weeks, I argue that ought to be up to you to negotiate and not have the goverment awkwardly intervene with a tax policy that tries to define differently who is doing what. That said, it’s perfectly reasonable to argue against my position here; I’m just saying, I don’t think it’s practically reasonable to argue against it purely on the limited case of how VC carried interest is treated, without thinking about what happens to treatment of all the other deal structures and players throughout the small business and entrepreneurial economy, because I don’t think it’s possible in the end to differentiate them.

4. Finally, if you agree from #1 that it’s good policy to tax capital gains differently than ordinary income, and from #2 that it’s okay to apply cap gains in some cases to situations where the capital gain was created from an intangible contribution, and from #3 that it’s okay to allow individual players to negotiate their share of the cash vs. intangible contribution, then we end up in a final question of whether or not this practical “technology” of a policy approach, as opposed to a philosophical or ideological approach, ends up creating more benefit or less. Here, you simply have to decide, do you believe some version of the many studies that show the enormous benefit to the USA economy and private sector job creation from having incentives to the various players who support non-leveraged, long-term, high-risk start-up company growth? If, like some bloggers, you simply think it’s all baloney and PR hype, then it is reasonable to argue that the government shouldn’t bother to stimulate this area. (You probably think they should do more to pay farmers not to grow corn). If, like me, you think that the directional trend of all the studies is pretty conclusive, regardless of any quibbles about particular numbers and particular metholdogies, then I would argue that it’s pretty damn important for government tax policy to do everything it can to incentivize this type of company growth, recognizing that more often than not, the entrepreneurs and the investors and the employees come away with nothing, but when it does work in the minority of cases, it works so well that it has literally driven nearly all of our country’s economic and productivity gains in the last 30 years.

So, there’s my long-winded articulation of how I see the world. As always, your mileage may vary and I respect the opinions of well-mannered people committed to thinking the issue through.